10 Bogus Investing 'Truths'

Brett Arends: In this market, the conventional wisdom no longer holds.

This market isn't just pounding your portfolio. It's also smashing some of the biggest myths that investors have lived on for a generation.

You can't time the market. So much for that. Two metrics have done a very good job of telling you over the decades when to be in stocks and when to be out of them. And both appear to be on the money once again: They were flashing red for months leading up to the summer swoon.

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The first, called Tobin's q, compares share prices to the cost of rebuilding those companies' assets from scratch. The logic is obvious: Why would you pay $1 billion to buy a company if you could start an identical one, with identical assets, for, say, $700 million? The second metric is the 'cyclically-adjusted' price-to-earnings ratio, also known as the "Shiller PE" after Yale professor Robert "Irrational Exuberance" Shiller, who has popularized it. The measure compares stock prices to average earnings over the past 10 years, in contrast with a typical P/E which is a one-year snapshot.

Both measures continue to signal caution, though less than they did six months ago. The Shiller measure can be found on the professor's website. Tobin's q is trickier: it requires sifting through the Federal Reserve's quarterly Flow of Funds report.

The cash on the sidelines will drive this market higher. How often have we heard this? Not long ago I met a bunch of professional investors, and this line came up again.

But it's a total myth. Take a deep breath, please. For every buyer of a stock, someone else must be a seller. Sorry, but there it is. If someone "on the sidelines" takes $1,000 in cash and uses it to buy, say, Exxon Mobil stock, then someone else must sell $1,000 of Exxon Mobil stock … and take the cash.

Markets are efficient. You know the line: Stock and bond prices reflect all available information. Attempts to outperform are fruitless.

Not long ago, this myth dominated Wall Street and financial theory. The Supreme Court even relied on it in rulings.

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But this is nonsense. Three months ago Greek government bonds were already trading as if a default were nearly inevitable. The yield on the one-year Greek bond was 35%. At the same time, the Russell 2000 index of small company stocks was at 850, nearly an all-time high – and a record compared to the price of large company stocks.

So back then, the "efficient" market was simultaneously betting that Greece would default, small companies would keep booming, and investors would continue to want more risk in their portfolios. On which planet?

Share buybacks will drive the market higher. We've been told over and over again that companies have "record amounts of cash on the balance sheet," and that this should be great for stockholders. After all, they are going to return that cash to investors by buying back shares. And that should raise the stock price by reducing the amount of shares in issue.

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So much for that. S&P 500 companies spent a massive $103 billion buying back their stock in the second quarter, on top of a thumping $85 billion in the first quarter. And the results so far haven't been that impressive. InsiderScore reports that the second quarter figure was the highest amount spent on share buybacks "since the first quarter of 2008." Hmm. How'd that work out?

Turns out this logic was flawed in about three different ways. First, the "record cash on the balance sheets" is matched by record debts. Second, if a company spends $100 million buying back stock, it should, rationally, make no real difference to the share price: The market value should fall by $100 million. Third, "buybacks" are largely a fiction: While the company spends stockholders' money buying in stock, the compensation committee quietly hands out new stock to executives.

Net result: You're actually going backwards. Standard & Poor's reports that from 2000 through 2010, S&P 500 members spent a massive $2.7 trillion buying in stock. Yet at the end of the decade they actually had more shares and options outstanding than they did at the beginning.

To get higher returns you have to take on more risk. This one is still alive. But is it really so straightforward? Back in 2000 I had lunch in London with a very wise old portfolio manager. He told me to sell all my stocks and buy inflation-protected U.S. bonds. As it happens I didn't own many stocks, but I was a young whipper-snapper who had grown up during a two-decade bull market, and I didn't see much appeal in TIPS – the "safest," supposedly dullest, investment around. After all, wasn't a young investor supposed to be taking on "risk"?

Since then, the Vanguard Inflation Protected Securities Fund has more than doubled your money. That's been a spectacular result – from the "safest" investment around. Meanwhile the risky Standard & Poor's 500-stock index has actually lost money. (Over the same lunch the same manager also told me to buy gold. We keep in touch).

In early 2007, according to an analysis by fund firm GMO, the relationship between "risk" and return was actually upside down. At that point, they said, "risky" investments were so overpriced that they were virtually guaranteed to produce worse returns than "safe" investments. In other words, investors were not being "paid to take on risk" -- they were actually paying for the privilege.

Japan can't happen to us. For the past decade, we have been told, repeatedly, that the fate that has befallen Japanese investors – two decades of losses, with no end in sight – couldn't possibly happen to us. We're America! We have a much freer and more open economy. We have price disclosure and free markets. We have great productivity gains, unlike their "stagnant" economy. Did I mention we're America?

Ha. Since the peak in 2000, investors in the U.S. stock market have lost 30% in real terms. And even after that decline, the U.S. market is far from cheap. All sorts of things that befell Japan are now happening to us: Collapsing interest rates, sagging real estate, and an economy that cannot generate a strong, sustainable recovery. Turns out even the productivity story is a myth: When you compare real output per worker, Japan's growth over the past 20 years looks much like ours. As for the stock market? According to data from MSCI, over the past ten years the total returns from the Japanese stock market, when measured in U.S. dollars, have been about the same as those of the U.S.

Don't fight the Fed. This is one of the best-known yarns on the Street. When the Fed cuts interest rates, buy stocks. Cheap money means stocks are going higher. And for a long time it worked.

Not now. Two months ago, the Fed signaled it was going to keep interest rates on hold for another two years, and soon thereafter began signaling the launch "Operation Twist," a campaign to cut long-term rates.

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So far, investors have had little to show for it but turmoil. The S&P 500 is down about 4% and the Russell 2000 about 7%.

And when you take a step back, this is part of a bigger picture. The Fed has been cutting rates for over a decade. And during that time stocks have done, overall, very poorly indeed.

Don't bet against America! This may have been the cheesiest line brokers ever used, but it didn't stop them using it. The theory was that American stocks were the "best", and had always offered the best returns and the greatest safety. The implication was that anyone who wasn't a bull was somehow unpatriotic. (When the Dow fell out of bed, as it frequently did, the "Don't bet against America" crowd resorted to blaming the Federal Reserve).

But U.S stocks and the U.S. economy have turned out to be very different things. Over the past two years, for example, the stock market is up about 10%. Yet the real economy has shown little such improvement, if any. A smaller share of the population is working. And average wages, adjusted for inflation, have actually fallen by 1%.

As for a lack of the alleged better returns? Over the past decade, according to FactSet, the U.S. stock market has been one of the worst performers in the world. It has been left in the dust by emerging markets. Among developed markets, only Belgium, Greece, Ireland and Italy have done worse.

Cash is trash. We've been told for a generation that cash is a terrible investment, and you need to "put it to work" in stocks and bonds as fast as possible. A generation ago, big institutions often held 7% or more of a portfolio in cash. For the past decade or so, it's been barely half that, according to a monthly survey by Merrill Lynch (now Bank of America Securities).

Turns out there are many worse investments than cash: Like overvalued stocks. As for "putting money to work", what kind of analogy is that? You've lost money. If your employer bills you for your own labor, find another employer.

Your portfolio should match your age. Young people should have one type of portfolio, with lots of small cap stocks and emerging market and other "risky" stuff. Middle-aged people should have another, with more bonds and large cap value funds. And senior citizens should have another, mostly bonds and cash.

Think of all the portfolios, including "target date" and "lifecycle" mutual funds, built on this foundation.

But it's another myth. As pointed out above, for example, younger investors would have done a lot better over the past decade with lots of bonds. Today older investors putting most of their money in "safe" bonds may be making the opposite mistake. The ten-year Treasury yields 2% and the 30-year less than 3%. Retirees who held lots of "safe" U.S. government bonds back in the sixties and seventies found themselves anything but safe: Their purchasing power collapsed in the face of surging inflation.

The truth: No one can rely on such simple rules. It depends on the prices you pay for securities. A source tells me of highly profitable, stable, medium-sized Japanese companies, with no debt, whose shares now trade at a discount to the net cash they hold in their bank accounts. But according to the "age-appropriate" myth, such investments are highly risky because they are "foreign mid-cap stocks." Apparently you've been much "safer" investing in "large cap value" U.S. stocks like…er… Bank of America.

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